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Andrew Ang
Columbia University and NBER
Geert Bekaert
Columbia University, NBER and CPER
We examine the predictive power of the dividend yields for forecasting excess returns,
cash flows, and interest rates. Dividend yields predict excess returns only at short
horizons together with the short rate and do not have any long-horizon predictive
power. At short horizons, the short rate strongly negatively predicts returns. These
results are robust in international data and are not due to lack of power. A present
value model that matches the data shows that discount rate and short rate movements
play a large role in explaining the variation in dividend yields. Finally, we find that
earnings yields significantly predict future cash flows. (JEL C12, C51, C52, E49,
F30, G12)
We thank Xiaoyan Zhang for help with data. We thank Kobi Boudoukh, Michael Brandt, John
Campbell, John Cochrane, George Constantinides, Cam Harvey, Bob Hodrick, Charles Jones, Owen
Lamont, Martin Lettau, Jun Liu, Sydney Ludvigson, Chris Neely, Jim Poterba, Tano Santos, Bob
Shiller, Tim Simin, Ken Singleton, Rob Stambaugh, Meir Statman, Jim Stock, Ane Tamayo, Samuel
Thomson, Ivo Welch, Jeff Wurgler, and seminar participants at Columbia University, Duke University,
INSEAD, London Business School, the NY Federal Reserve, NYU, Stanford University, UC San Diego,
Wharton, Yale, the American Finance Association, an NBER Asset Pricing meeting, the European
Finance Association, and the Western Finance Association for helpful comments. We also thank three
anonymous referees and Yacine Aı̈t-Sahalia (the editor) for valuable, extensive comments that greatly
improved the article. Andrew Ang thanks the Chazen Institute at Columbia Business School for financial
support. Geert Bekaert thanks the NSF for financial support. Address correspondence to Geert Bekaert,
Columbia Business school, Room 802, Uris Hall, 3022 Broadway, New York, NY 10027, or e-mail:
gb241@columbia.edu.
1
Among those examining the predictive power of the dividend yield on excess stock returns are Fama and
French (1988), Campbell and Shiller (1988a,b), Goetzmann and Jorion (1993, 1995), Hodrick (1992),
Stambaugh (1999), Wolf (2000), Goyal and Welch (2003, 2004), Engstrom (2003), Valkanov (2003),
Lewellen (2004), and Campbell and Yogo (2006).
The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights
reserved. For permissions, please email: journals.permissions@oxfordjournals.org.
doi:10.1093/rfs/hhl021 Advance Access publication July 6, 2006
The Review of Financial Studies / v 20 n 3 2007
2
Authors examining the predictability of excess stock returns by the nominal interest rate include Fama
and Schwert (1977), Campbell (1987), Breen, Glosten, and Jagannathan (1989), Shiller and Beltratti
(1992), and Lee (1992).
652
Stock Return Predictability
3
Given the excellent performance of Hodrick (1992) standard errors, we do not rely on the alternative
inference techniques that use unit root, or local-to-unity, data generating processes (see, among others,
Richardson and Stock 1989, Richardson and Smith 1991, Elliot and Stock 1994, Lewellen 2004, Torous,
Valkanov, and Yan 2004, Campbell and Yogo 2006, Polk, Thompson, and Vuolteenaho 2006, Jansson
and Moreira 2006). One major advantage of Hodrick standard errors is that the set up can handle
multiple regressors, whereas the inference with unit root type processes relies almost exclusively on
univariate regressors. The tests for multivariate predictive regressions using local-to-unity data generating
processes developed by Polk et al. (2006) involve computationally intensive bootstrapping procedures.
This test also has very poor size properties under the nonlinear present value we present in Section 4.
These results are available upon request.
653
The Review of Financial Studies / v 20 n 3 2007
1. Data
We work with two data sets, a long data set for the United States, United
Kingdom and Germany and a shorter data set for a sample of four
countries (United States, United Kingdom, France, and Germany). In
the data, dividend and earnings yields are constructed using dividends
and earnings summed up over the past year. Monthly or quarterly fre-
quency dividends and earnings are impossible to use because they are
dominated by seasonal components.
We construct dividend growth and earnings growth from these ratios,
producing rates of annual dividend or earnings growth over the course of
a month or a quarter. To illustrate this construction, suppose we take the
frequency of our data to be quarterly. We denote log dividend growth at a
quarterly frequency as gtd,4 , with the superscript 4 to denote that it is
constructed using dividends summed up over the past year (four quar-
ters). We compute gtd,4 from dividend yields D4t =Pt , where the dividends
are summed over the past year, using the relation
D4t =Pt Pt
gtd,4 ¼ log , ð1Þ
D4t1 =Pt1 Pt1
654
Stock Return Predictability
and were purchased from Global Financial Data. All the long sample
data for the United States, United Kingdom, and Germany are at the
quarterly frequency, and we consequently use three-month T-bills as
quarterly short rates.
Panel A of Table 1 lists summary statistics. US earnings growth is
almost as variable as returns, whereas the volatility of dividend growth
is less than half the return volatility. The variability of UK and German
dividend growth rates is of the same order of magnitude as that of
returns. The instruments (short rates, dividend and earnings yields) are
all highly persistent. Because the persistence of these instruments plays a
crucial role in the finite sample performance of predictability test statis-
tics, we report test statistics under the null of a unit root and a stationary
process in Panel A. Investigating both null hypotheses is important
because unit root tests have very low power to reject the null of a
stationary, but persistent, process.
In the United Kingdom and Germany, dividend yields are unambigu-
ously stationary, as we reject the null of a unit root and fail to reject the
null of stationarity at the 5% level. For the US dividend yield, the
evidence for non-stationarity is weak as we fail to reject either hypothesis.
This is surprising because the trend toward low dividend yields in the
1990s has received much attention. Figure 1 plots dividend yields for the
Table 1
Sample moments, unit root, and stationarity tests
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The Review of Financial Studies / v 20 n 3 2007
Table 1
(continued)
Panel A reports summary statistics of long-sample data for the United States, United Kingdom, and
Germany, all at a quarterly frequency. Panel B reports statistics for monthly frequency Morgan Stanley
Capital International MSCI data. Excess returns and short rates are continuously compounded. Sample
means and standard deviations (Stdev) for excess
pffiffiffiffi pffiffiffiffiffi returns, dividend, and earnings growth have been
annualized by multiplying by 4 (12) and 4 ð 12Þ, respectively, for the case of quarterly (monthly)
frequency data. Short rates for the long-sample (MSCI) data are three-month T-bill returns (one month
EURO rates). Dividend and earnings yields, and the corresponding dividend and earnings growth are
computed using dividends or earnings summed up over the past year. In Panel A, the unit root test is the
Phillips and Perron (1988) test for the estimated regression xt ¼ þ xt1 þ ut under the null
xt ¼ xt1 þ ut . The critical values corresponding to p-values of 0.01, 0.025, 0.05, and 0.10 are 3:46,
3:14, 2:88, and 2:57, respectively. The test for stationarity is the Kwiatkowski et al. (1992) test. The
critical values corresponding to p-values of 0.01, 0.025, 0.05, and 0.10 are 0.739, 0.574, 0.463, 0.347,
respectively.
*p<0.05.
**p<0.01.
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Stock Return Predictability
0.12
US
UK
Germany
0.1
0.08
0.06
0.04
0.02
0
1940 1950 1960 1970 1980 1990 2000
Figure 1
Dividend yields over the long sample
We plot dividend yields from June 1935 to December 2001 for the United States and from March 1953 to
December 2001 for the United Kingdom and Germany.
657
The Review of Financial Studies / v 20 n 3 2007
1975 to December 2001. We use the one-month EURO rate from Data-
stream as the short rate.
Panel B of Table 1 shows that the United States has the least variable
stock returns with the least variable cash flow growth rates. The extreme
variability of French earnings growth rates is primarily due to a few
outliers between May 1983 and May 1984, when there are very large
movements in price-earnings ratios. Without these outliers, the French
earnings growth variability drops to 33%. The variability of short rates,
dividend, and earnings yields is similar across countries. The equity pre-
mium for the United States, France, Germany, and the United Kingdom
roughly lies between 4 and 6% during this sample period. Dividend yields
and short rates are again very persistent over the post-1975 sample. We
also report excess return correlations showing that correlations range
between 0.47 and 0.60. The correlations for the United States, United
Kingdom, and Germany are similar to the correlations over the post-1953
period reported in Panel A.
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Stock Return Predictability
XT
^0 ¼ 1
S wkt wkt , ð3Þ
T t¼k
where
!
X
k1
wkt ¼ "tþ1,1 xti :
i¼0
659
The Review of Financial Studies / v 20 n 3 2007
0.105 4
3.5
0.1
Coefficient
T−stat
2.5
0.095
0.09 1.5
1
0.085
0.5
0.08 0
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Horizon (quarters) Horizon (quarters)
0.1
4
0.09 3.5
Coefficient
3
T−stat
0.08
2.5
0.07 2
1.5
0.06
1
0.05
0.5
0.04 0
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Horizon (quarters) Horizon (quarters)
5
0.24
4.5
0.23
4
0.22
3.5
Coefficient
0.21 3
T−stat
0.2 2.5
2
0.19
1.5
0.18
1 Robust Hansen−Hodrick
Hodrick
0.17 Newey−West
0.5
0.16 0
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Horizon (quarters) Horizon (quarters)
Figure 2
Dividend yield coefficients and t-statistics from US regressions
The left (right) column shows the dividend yield coefficients k (t-statistics) in the regression
~ytþk ¼ þ k dy4t þ "tþk,k , where ~ytþk is the cumulated and annualized k-quarter ahead excess return
and dy4t is the log dividend yield. T-statistics are computed using Robust Hansen-Hodrick (1980),
Hodrick (1992) or Newey-West (1987) standard errors. The quarterly data is from Standard and Poors.
660
Stock Return Predictability
rises until the one-year horizon, and then decreases, before increasing
again near 20 quarters.
Over 1935–2001, the Hodrick t-statistic is above 2 only for horizons 2–
4 quarters. However, there is no evidence of short-run predictability (at
the one-quarter horizon) or long-horizon predictability. We draw a very
different picture of predictability if we use Newey–West or robust
Hansen–Hodrick t-statistics, which are almost uniformly higher than
Hodrick t-statistics. Using Newey–West standard errors, the evidence in
favor of predictability would extend to eight quarters for the full sample.
Over the 1952–2001 sample, there is no evidence of predictability,
whereas for the 1935–1990 period, the evidence for predictability is very
strong, whatever the horizon, with all three t-statistics being above 2.4.
Table 2 summarizes the excess return predictability results for horizons
of one month (quarter), one year, and five years. We only report
t-statistics using Hodrick standard errors. In addition to the sample
periods shown in Figure 2, we also show the 1952–1990 period, which is
close to the 1947–1994 sample period in Lamont (1998). When we omit
the 1990s, we confirm the standard results found by Campbell and Shiller
(1988a,b) and others: the dividend yield is a significant predictor of excess
Table 2
Predictability of US excess returns
Univariate
regression Bivariate regression
12
k-mths dy r dy12 2 test
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The Review of Financial Studies / v 20 n 3 2007
Table 2
(continued)
Univariate
regression Bivariate regression
returns at all horizons. However, when we use all the data, we only find
5% significance at the one-year horizon for the longest sample. A test for
predictability by the dividend yield jointly across horizons rejects with a
p-value of 0.014 for the 1935–1990 period, but fails to reject with a
p-value of 0.587 over the whole sample, even though the shorter horizon
t-statistics all exceed 1.5 in absolute value. While it is tempting to blame
the bull market of the 1990s for the results, our data extend until the end
of 2001 and hence incorporate a part of the bear market that followed.
For the 1975–2001 sample, reported in Panel B, the dividend yield also
fails to predict excess returns.
Table 2 also reports bivariate regression results with the short rate as an
additional regressor. For the post-Treasury Accord 1952–2001 sample, a
1% increase in the annualized short rate decreases the equity premium by
about 2.16%. The effect is significant at the 1% level. A joint test on the
interest rate coefficients across horizons rejects strongly for both the
1952–2001 period ðp-value ¼ 0:004Þ and the 1952–1990 period
ðp-value ¼ 0:000Þ. The predictive power of the short rate dissipates
quickly for longer horizons but remains borderline significant at the 5%
level at the one-year horizon.4 If expected excess returns are related only
to short rates and short rates follow a univariate autoregressive process,
the persistence of the interest rate (0.955 in Table 1) implies that the
coefficient on the short rate should tend to zero slowly for long horizons.
In fact, the decay rate should be 1=k ð1 k Þ=ð1 Þ for horizon k. The
4
The results do not change when a detrended short rate is used instead of the level of the short rate or when
we use a dummy variable over the period from October 1979 to October 1982 to account for the monetary
targeting period.
662
Stock Return Predictability
decay rate in data is clearly more rapid, indicating that either expected
excess returns or risk-free rates, or both, are multifactor processes.
In the bivariate regression, the dividend yield coefficient is only signifi-
cant at the 5% level for the one-quarter horizon. Joint tests reject at the 1%
(5%) level for the one-quarter (four-quarter) horizon but fail to reject at
long horizons. When we omit the 1990s, the predictive power of the short
rate becomes even stronger. A joint predictability test still fails to reject the
null of no predictability at long horizons, but the p-value is borderline
significant (0.052). Over the 1975–2001 sample, the coefficient on the short
rate remains remarkably robust and is significant at the 5% level. While the
coefficient on the dividend yield is no longer significantly different from
zero, it is similar in magnitude to the full sample coefficient and a joint test
is borderline significant ðp-value ¼ 0:057Þ. The Richardson (1993) joint
predictability test over all horizons and both predictors rejects at the 1%
level in the samples excluding the 1990s and the full sample, rejects at the
5% level for 1952–2001, and rejects at the 10% level for 1975–2001.
Looking at the 1951–2001 and 1975–2001 samples, the evidence for the
bivariate regression at short horizons is remarkably consistent. Moreover,
the coefficient on the dividend yield is larger in the bivariate regression
than in the univariate regression. This suggests that the univariate regres-
sion suffers from an omitted variable bias that lowers the marginal impact
of dividend yields on expected excess returns. Engstrom (2003), Menzly,
Santos, and Veronesi (2004), and Lettau and Ludvigson (2005) also note
that a univariate dividend yield regression may understate the dividend
yield’s ability to forecast returns.
663
The Review of Financial Studies / v 20 n 3 2007
US dy coefficient US t−stat
0.1
2
0.05
1
0
−0.05 0
−0.1 −1
UK dy coefficient UK t−stat
0.35
2
0.3
0.25 1
0.2
0
0.15
0.1 −1
FR dy coefficient FR t−stat
0.06
2
0.04
1
0.02
0 0
−0.02 −1
GR dy coefficient GR t−stat
0.04
2
0.02
1
0
−0.02 0
−0.04 −1
0 10 20 30 40 50 60 0 10 20 30 40 50 60
Horizon (months) Horizon (months)
Figure 3
Dividend yield coefficients and t-statistics in four countries
The left (right) column shows the dividend yield coefficients k (t-statistics) in the regression
~ytþk ¼ þ k dy12
t þ "tþk,k , where ~ytþk is the cumulated and annualized k-month ahead excess return
and dy12
t is the log dividend yield. T-statistics are computed using Hodrick (1992) standard errors. The
monthly data is from MSCI and the sample period is from 1975 to 2001.
very shortest horizons. These results are opposite to the results in a recent
study by Campbell (2003), who reports strong long-horizon predictability
for France, Germany, and the United Kingdom over similar sample
periods. We find that Campbell’s conclusions derive from the use of
Newey–West (1987) standard errors, and the predictability disappears
when Hodrick (1992) standard errors are employed.
For the United Kingdom and Germany, we also investigate the longer
1953–2001 sample in Panel A of Table 3. The first column reports the
univariate dividend yield coefficients. We only find significance at the
one-year horizon for the UK, but the coefficients are all positive and
more than twice as large as the US coefficients.5 Germany’s dividend yield
5
For the United Kingdom, we also looked at a sample spanning 1935–2001, where we find a significant
univariate dividend yield coefficient at the five-year horizon but not at the one-quarter horizon.
664
Stock Return Predictability
Table 3
Excess return regressions across countries
Univariate
regression Bivariate regression
Univariate
regression Bivariate regression
We estimate regressions of the form ~ytþk ¼ k þ zt þ "tþk,k where y~tþk is the cumulated and annualized
k-period ahead excess return, with instruments zt being log dividend yields or risk-free rates and log
dividend yields together. T-statistics in parentheses are computed using Hodrick (1992) standard errors.
Panel A estimates the regression pooling data across the United States, United Kingdom, and Germany
on data from 1953–2001. The estimates listed in the United Kingdom and Germany panels allow each
country to have its own predictive coefficients and intercepts, but we compute Seemingly Unrelated
Regression (SUR) standard errors following the method outlined in the Appendix. The coefficients listed
in the pooled panel are produced by constraining the predictive coefficients to be the same across
countries. In Panel B, monthly frequency MSCI data is used from 1975–2001. The column labeled ‘‘2
test’’ reports a p-value for a test that both the risk-free rate and log dividend yield coefficients are jointly
equal to zero. The ‘‘J-test’’ columns report p-values for a 2 test of the overidentifying restrictions.
*p<0.05.
**p<0.01.
coefficients are the same order of magnitude than those of the United
States, but are all insignificant.
Figure 4 displays the coefficient patterns for the annualized short rate
and its associated t-statistics in the bivariate regression for the 1975–2001
sample. Strikingly, this coefficient pattern is very robust across countries.
For all countries, the one-month coefficient is negative, below 3 for
665
The Review of Financial Studies / v 20 n 3 2007
US rf coefficient US t−stat
1 2
1
0
0
−1
−1
−2
−2
−3 −3
UK rf coefficient UK t−stat
−0.5 2
1
−1
0
−1.5
−1
−2
−2
−2.5 −3
FR rf coefficient FR t−stat
0.5 2
0 1
−0.5 0
−1 −1
−1.5 −2
−2 −3
GR rf coefficient GR t−stat
2 2
1
0
0
−1
−2
−2
−4 −3
0 10 20 30 40 50 60 0 10 20 30 40 50 60
Horizon (months) Horizon (months)
Figure 4
Short rate coefficients from bivariate regressions in four countries
The left (right) column shows the risk-free rate coefficients k (t-statistics) from the bivariate regression
~ytþk ¼ þ zt k þ "tþk,k , where ~ytþk is the cumulated and annualized k-month ahead excess return and
zt ¼ ðrt dy12
t Þ contains the annualized risk-free rate and the log dividend yield. We report only the short
rate coefficient. T-statistics are computed using Hodrick (1992) standard errors. The monthly data is
from MSCI and the sample period is from 1975 to 2001.
666
Stock Return Predictability
the five-year horizon. Similar to the United States, the dividend yield
coefficients are larger in the bivariate regressions than in the univariate
regression. However, the dividend yield coefficient is still only signifi-
cantly different from zero at the 5% level in the United Kingdom at the
one-year horizon.
To obtain more clear-cut conclusions, Table 3 reports pooled predict-
ability coefficients and tests. We pool across the United States, United
Kingdom, and Germany for the long sample in Panel A, and pool across
all four countries in Panel B. The univariate dividend yield regression
delivers mixed evidence across the two samples. For the long sample, the
dividend yield coefficients are larger than 0.10 at the one-quarter and one-
year horizons and statistically significant at the 5% level. The joint pre-
dictability tests for the shorter sample reveal a pattern of small dividend
yield coefficients that decrease with horizon and are never significantly
different from zero. We also report a J-test of the overidentifying restric-
tions for the joint estimation (see Appendix C). This test fails to reject for
all horizons in both the long and short samples, which suggests that
pooling is appropriate.
What is most striking about the bivariate regression results across the
long and short samples is the consistency of the results. At the one-period
forecasting horizon, the short rate coefficient is 1:96 in the long sample
and 1:82 in the short sample, both significant at the 1% level. The
bivariate regression also produces a dividend yield coefficient around
0.16 that is significant at the 1% (5%) level in the long (short) sample.
Not surprisingly, the joint test rejects at the 5% level. However, for the
short sample, the test of the overidentifying restrictions rejects at the 5%
level, suggesting that pooling may not be appropriate for this horizon.
For longer horizons, this test does not reject, and the evidence for
predictability weakens. Nevertheless, for the long sample, we still reject
the null of no predictability at the 1% level for the one-year horizon.
We conclude that whereas the dividend yield is a poor predictor of
future returns in univariate regressions, there is strong evidence of pre-
dictability at short horizons using both dividend yields and short rates as
instruments. The short rate is the stronger predictor and predicts excess
returns with a coefficient that is negative in all four countries that we
consider.
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The Review of Financial Studies / v 20 n 3 2007
d d
Denoting gtþ1 as log dividend growth, gtþ1 ¼ logðDtþ1 =Dt Þ, we can rear-
range (4) and iterate forward to obtain the present value relation:
" !#
Pt X 1 X
i1 Xi
d
¼ Et exp tþj þ gtþj , ð5Þ
Dt i¼1 j¼0 j¼1
6
Goyal and Welch (2003) show that in a Campbell and Shiller (1988a,b) log-linear framework, the
predictive coefficient on the log dividend yield in a regression of the one-period total return on a constant
and the log dividend yield can be decomposed into an autocorrelation coefficient of the dividend yield
and a coefficient reflecting the predictive power of dividend yields for future cash-flows. In Section 4, we
attribute the time variation of the dividend yield into its three possible components—risk-free rates,
excess returns, and cash flows—using a nonlinear present value model.
668
Stock Return Predictability
Table 4
Predictability of dividend growth
Univariate
regression Bivariate regression
Panel B: pooled across the United States, United Kingdom, and Germany
1953–2001 1 0.1545 0.6991 0.1677 0.000**
(15.54)** (4.296)** (14.16)**
4 0.1552 0.4897 0.1642 0.000**
(14.64)** (3.005)** (13.19)**
20 0.0489 0.2678 0.0555 0.030*
(2.544)* (2.276) (2.452)*
Univariate
regression Bivariate regression
Panel C: pooled across United States, United Kingdom, Germany, and France
1975–2001 1 0.0179 0.3248 0.0371 0.616
(0.757) (1.194) (1.286)
12 0.0116 0.3348 0.0082 0.377
(0.440) (1.511) (0.281)
60 0.0077 0.0702 0.0025 0.266
(0.138) (0.359) (0.059)
We estimate regressions of cumulated and annualized k-period ahead dividend growth, on log dividend
yields alone or risk-free rates and log dividend yields together. Panels B and C pool data jointly across
countries, constraining the predictive coefficients to be the same across countries. The 2 test column
reports a p-value for a test that both the risk-free rate and log dividend yield coefficients are jointly equal
to zero. T-statistics in parentheses are computed using Hodrick (1992) standard errors.
*p<0.05.
**p<0.01.
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The Review of Financial Studies / v 20 n 3 2007
coefficients) reject at the 1% level for both the one- and four-quarter
horizons.
Campbell and Shiller (1988a,b) note that the approximate linear relation
(6) implies a link between high dividend yields today and either high future
returns, or low future cash flows, or both. Hence, the positive sign of the
dividend yield coefficient in the short sample is surprising. However, the
Campbell–Shiller intuition is incomplete because it relies on a linear
approximation to the true present value relation (5). Positive dividend
yield coefficients in predictive cash-flow regressions can arise in rational
models. For example, Ang and Liu (2006) show how the nonlinearity of the
present value model can induce a positive dividend yield coefficient.
Menzly, Santos, and Veronesi (2004) show that the dividend yield coeffi-
cient is a function of a variable capturing shocks to aggregate preferences.
Consequently, it changes over time and can take positive values.
In Panels B and C of Table 4, we investigate the relation between
dividend yields and cash-flows for other countries. Panel B pools data
across the United States, United Kingdom, and Germany for the 1953–
2001 sample. Unlike the US post-1952 sample, the dividend yield coeffi-
cients are strongly negative. Because the United Kingdom and German
coefficients are so different from the United States (data not shown), a
pooled result is hard to interpret, and the GMM over-identifying restric-
tions are strongly rejected with a p-value of less than 0.001. Nevertheless,
pooling yields negative, not positive, dividend yield coefficients. The
short rate coefficients are strongly positive and are about twice the
magnitude of the US coefficients (a 1% increase in the short rate approxi-
mately forecasts an annualized 70 basis point increase in expected divi-
dend growth over the next quarter).
Panel C reports coefficients for the MSCI sample. The dividend yield
coefficients are small, mostly negative and never statistically significantly
different from zero. The short rate coefficients are also insignificant,
although they are similar in magnitude to the coefficient found in long-
term US data. There is no general pattern in the individual country
dividend yield coefficients (data not shown): the dividend yield coefficient
in the univariate regression is positive (negative) in the United States and
United Kingdom (France and Germany), with the dividend yield coeffi-
cients retaining the same signs in the bivariate regression in each country.
All in all, we conclude that the evidence for linear cash-flow predictability
by the dividend yield is weak and not robust across countries or sample
periods.7
7
It is conceivable that dividend yields exhibit stronger predictive power for real dividend growth. However,
we find the results for real and nominal growth to be quite similar. In the long US sample, the dividend
yield fails to forecast future ex-post real dividend growth and the coefficients are positive. For the shorter
sample, pooled results across the four countries produce negative coefficients that are actually significant
at short horizons. These results are available upon request. Campbell (2003) also finds analogous results.
670
Stock Return Predictability
Table 5
Predictability of risk-free rates
Panel A: US Data
1952–2001 1 0.0171 0.0458
(0.202) (0.416)
4 0.0161 0.0429
20 0.0267 0.0413
We estimate regressions of cumulated and annualized k-period ahead average risk-free rates by log
dividend yields. The detrended log dividend yield refers to the difference between the log dividend yield
and a moving average of log dividend yields over the past year. Panel c pools data across countries. We
compute Cochrane-Orcutt t-statistics (in parentheses) for a one-quarter horizon.
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The Review of Financial Studies / v 20 n 3 2007
basis next quarter). Using a detrended dividend yield also leads to the
same positive sign. While both effects are statistically insignificant, we
view the relationship between dividend yields and future interest rates as
economically important because interest rates are a crucial component of
a present value relation. From the present value relation (5), we expect a
positive relation between dividend yields and future discount rates. The
interest rate enters the discount rate in two ways. The discount rate is the
sum of the risk-free rate and the risk premium and enters these two
components with opposite signs. It is the first component that gives rise
to the positive relation.
Although not statistically significant, the positive sign of interest rate
predictability by dividend yields is robust. First, omitting the 1990s does
not change the inference, but actually increases the t-statistics. Second, we
also find a positive sign for Germany and the United Kingdom in the
long sample and for all countries in the short sample. In particular, for
MSCI data, the individual coefficients range from 0.036 in the United
States to 0.085 in France at the one-month horizon.8
Xt ¼
þ Xt1 þ "t , ð7Þ
where Xt ¼ ðrt , gtd Þ and "t IID Nð0,Þ. Let the discount rate, t , in
Equation (4) follow the process:
t ¼ þ Xt þ t1 þ ut , ð8Þ
with ut IID Nð0,
2 Þ and "t and ut are independent. We denote the
individual components of as ¼ ðr , gd Þ .
8
We also examine the predictive power of the dividend yield for ex-post real interest rates, similar to
Campbell (2003). Although the individual coefficients across countries fail to have a consistent sign,
pooled results produce positive coefficients at all horizons, as in the nominal case. However, the
coefficients are not statistically significant.
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Stock Return Predictability
Proposition 4.1. Assuming that Xt ¼ ðrt , gtd Þ follows Equation (7) and
that the log conditional total expected return t follows (8), the price-
dividend ratio Pt =Dt is given by
Pt X 1
¼ expðai þ bi Xt þ ci t Þ, ð9Þ
Dt i¼1
where
1
aiþ1 ¼ ai þ ci þ c2i
2 þ ðe2 þ bi þ ci Þ
2
1
þ ðe2 þ bi þ ci Þ ðe2 þ bi þ ci Þ ð10Þ
2
biþ1 ¼ ðe2 þ bi þ ci Þ
ciþ1 ¼ ci 1,
where e2 ¼ ð0, 1Þ , ai and ci are scalars, and bi is a 2 1 vector. The initial
conditions are given by
1
a1 ¼ e2
þ e2 e2
2
ð11Þ
b1 ¼ e2
c1 ¼ 1:
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Pt expð
d þ 12
2d Þ
¼ :
Dt 1 expð
d þ 12
2d Þ
so regressing the simple net excess return on the interest rate actually yields a
nonzero coefficient on rt . The scaled expected return, Et ½Ytþ1 = expðrt Þ is
constant and equal to . The predictability regressions typically run in the
literature do not correspond to any of these two concepts, since they use
log returns ~ytþ1 logðYtþ1 Þ rt . In our economy, regressing log returns
onto state variables does not yield zero coefficients because the log excess
return is heteroskedastic. However, we would expect these coefficients to
be small, relative to the null of time-varying expected excess returns (where
t takes the full specification in Equation (8)).
Under the alternative of time-varying discount rates in Equation (8),
total expected returns can depend on both fundamentals (short rates and
dividend growth) and exogenous shocks. The case of ¼ 0 represents
fully exogenous time-varying expected returns. By specifying
t ¼ þ Xt , Equation (8) also nests the case of state-dependent
expected returns.
4.2 Estimation
The estimation of the present value model is complicated by the fact that
in the data, we observe dividends summed up over the past year, but we
specify a quarterly frequency in the model. We estimate the present value
model with simulated method of moments (SMM) (Duffie and Singleton
1993) on US data from January 1952 to December 2001. We provide full
details of the estimation in Appendix E.
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Stock Return Predictability
Table 6
Calibration of the present value model
1=2
rt gtd rt gtd
The table reports parameter estimates and standard errors in parentheses of the present value model.
Panel A reports estimates of the VAR of short rates and dividend growth in Equation (7). The short rate
rt equation is an AR(1), with standard errors produced by GMM with four Newey–West (1987) lags. The
parameters for gtd are estimated using SMM by matching first and second moments of gtd,4 , along with
the moments Eðrt gtd,4 Þ, Eðgt4
d,4 d,4
gt Þ, and Eðrt4 gtd,4 Þ. Panel B reports parameter estimates for the discount
rate process t ¼ þ Xt þ t1 þ ut [see Equation (8)], with ¼ ðr , gd Þ . The Null Models 1 and 2
impose the restriction
¼ gd ¼ ¼ 0, with r ¼ 0 for Null Model 1 or r ¼ 1 for Null Model 2. These
represent the null hypotheses of constant expected total returns (Null Model 1) or constant expected
excess returns (Null Model 2). Alternative Model 1 sets r ¼ gd ¼ 0, so the discount rate process is
entirely exogenous, whereas Alternative Model 2 imposes ¼ gd ¼ 0, so the discount rate process is
entirely endogenous. In Alternative Model 3, all parameters of the discount rate process are nonzero.
The estimation is done by holding the VAR parameters fixed and matching the first and second moments
of excess returns and dividend yields, along with lagged short rates and lagged dividend growth as
instruments. The last row reports the p-value from a 2 overidentification test.
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varz ðP=D4 Þ
1 , ð12Þ
varðP=D4 Þ
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Stock Return Predictability
Table 7
Economic implications of the present value model
US data
Panel C: correlations between true expected excess returns and forecasts from predictive regressions
k ¼ 1, univariate regression dy4 0.7364 0.7783 0.7859
k ¼ 1, bivariate regression dy4 ,r 0.9325 0.9785 0.8654
k ¼ 4, univariate regression dy4 0.7521 0.7684 0.7710
k ¼ 4, bivariate regression dy4 ,r 0.9328 0.9916 0.8297
k ¼ 20, univariate regression dy4 0.8506 0.7539 0.7976
k ¼ 20, bivariate regression dy4 ,r 0.9177 0.9971 0.8165
The table reports various economic and statistical implications from the present value models. Panel A
reports various moments and summary statistics implied from each model. The quarterly moments
reported are the mean and volatility of excess returns and dividend yields in levels. The data standard
errors of the moments are computed by GMM with four Newey–West (1987) lags. In Panel B, the
variance decompositions report the computation 1 varz ðP=D4 Þ=varðP=D4 Þ, where varðP=D4 Þ is the
variance of price-dividend ratios implied by the model, and varz ðP=D4 Þ is the variance of the price-
dividend ratios where all realizations of z ¼ rt , gt , t or the risk premium are set at their unconditional
means. Panel C reports the correlation between fitted values from the excess return predictive regressions
and true conditional expected excess returns Et ð~ytþk Þ implied by the model. The population moments
implied by the model are computed using 1,00,000 simulations from the estimates in Table 6. In Panel A,
the standard errors for the sample moments are computed using GMM.
*Indicates that the population moments lie outside a two standard deviation bound around the point
estimate of the sample moment.
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The Review of Financial Studies / v 20 n 3 2007
Alternative 3, the best fitting model, also perfectly matches the first-order
autocorrelation of the dividend yield (0.9596 compared to 0.9548 in US
data spanning 1952–2001). The variance decomposition of the various
models are as expected, given how the discount rates are modeled in each
specification: in Alternative 1, most variation comes from the exogenous
discount rate; in Alternative 2, almost all variation comes from the short
rate (which in turn drives variation in the discount rate), and in Alter-
native 3, the exogenous discount rate dominates but interest rates are still
important. Since Alternative 3 fits the data the best, the variance decom-
position is of considerable interest. It suggests that 61% of the price-
dividend ratio variation is driven by risk premiums, 22% by the short
rate and 7% by dividend growth. The remainder is accounted for by
covariance terms.
9
In a present value model, the economically relevant quantity for discount rates is the log expected return
t ¼ logððPtþ1 þ Dtþ1 Þ=Pt Þ ¼ logðEt ðYtþ1 ÞÞ. However, the predictive regressions produce a forecast of
expected log returns Et ðlogðYtþ1 ÞÞ. The two quantities logðEt ðYtþ1 ÞÞ and Et ðlogðYtþ1 ÞÞ are
P not equiva-
lent because of time-varying Jensen’s inequality terms. For example, the correlation of tþj rtþj in
Null Model 2 is zero with any variable, whereas the correlation of expected excess log returns Et ð~ytþk Þ is
not. We compute Et ð~ytþk Þ following the method described in Appendix E.
678
Stock Return Predictability
98% for all horizons. However, this alternative has the worst fit with the
data.
Table 8
Predictive regressions implied by the present value model
US data
k ¼ 1, univariate regression dy4 0.0342* 0.2142* 0.0008 0.1052* 0.0354 0.0171 0.0390
k ¼ 4, univariate regression dy4 0.0334 0.1928 0.0008 0.0946 0.0321 0.0161 –
k ¼ 20, univariate regression dy4 0.0230 0.1163 0.0016 0.0568 0.0194 0.0267 –
The table reports implied predictive regression coefficients from the present value models. The LHS
variables are cumulated log excess returns, dividend growth, and risk-free rates. The population moments
are computed using 1,00,000 simulations from the estimates in Table 6. The standard errors for the
regressions in US data are computed using Hodrick (1992) standard errors for the excess return and
dividend growth regressions and using a Cochrane-Orcutt procedure for the k ¼ 1 risk-free rate regres-
sion. All horizons k are in quarters.
*Indicates that the coefficients lie outside a two standard deviation bound around the point estimate of
the sample coefficient.
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negatively related to interest rates, which explains the large negative short
rate coefficients in the bivariate regressions. Because dividend yields are
correlated with interest rates, the univariate regression also picks up some
predictability. In the Null 2 model, expected excess returns are constant,
so that the only predictability we should observe comes from nonlinea-
rities. As in the Null 1 model, the coefficients on the dividend yield are
invariably small and of the wrong sign compared to the predictions in
Campbell and Shiller (1988a,b).
The alternative models imply different patterns of predictability. Despite
substantial variation in the exogenous discount rate, Alternative 1 generates
a population slope coefficient of only 0.089 in a dividend yield regression,
which is slightly below what is observed in the data. Because the discount
rate is not linked to the interest rate, an excess return projection on
dividend yields and the interest rate leads to coefficients on interest rates
in the neighborhood of 1 and a dividend yield coefficient of 0.088. Both
coefficients are somewhat lower in absolute magnitude than what is
observed in the data.
Alternative 2 implies a dividend yield predictability regression coeffi-
cient of 0.356. This is very close to the dividend yield coefficient for the
United States if we ignore the 1990s (0.296 in Table 2). Hence, in a world
where discount rates only depend on short rates and dividend growth, the
dividend yield would indeed be a strong predictor of excess returns.
However, because the variation in discount rates is mostly driven by
short rates, the dividend yield coefficient drops to 0.057 in a bivariate
regression and the predictable component is now mostly absorbed by the
short rate. This is inconsistent with the data, where bivariate regressions
yield larger dividend yield coefficients, not smaller ones.
Alternative 3 combines features of both Alternatives 1 and 2 and the
coefficients are nicely in between the two alternatives. This model also
yields a negative omitted variable bias in the univariate dividend yield
regression as is true in the data. Note that, with the exception of the
univariate slope coefficient in the dividend yield regression under Alter-
native 2, all predictability coefficients for all alternative models are within
two standard errors of the observed coefficients in the data.
4.4.2 Dividend growth regressions Table 8 also reports how the different
models fare with respect to the predictability of dividend growth. The main
feature in the data is that both dividend yields and short rates receive
positive coefficients in a bivariate regression. Since practically all of the
variation in dividend yields is due to dividend growth in the Null 1 model,
dividend growth is much too predictable in this model. Dividend growth
predictability in the Null 2 model is also inconsistent with the data.
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Table 9
Small sample bias under null model 2
Scaled returns
Univariate 1 dy4 0.0235 0.0045 0.0012 0.0000
Bivariate 1 r 0.3469 0.1799 0.1435 0.0000
dy4 0.0339 0.0286 0.0264 0.0000
The table reports small sample and population parameter coefficient values for regressions of scaled or
cumulated log excess returns onto log dividend yields (univariate regression) or annualized short rates
and log dividend yields (bivariate regression) from the Null 2 Model. Scaled returns are defined as
Ytþ1 = expðrt Þ, where Ytþ1 is the gross total equity return. The population moments from the model are
computed using 1,00,000 simulations. The small sample moments are computed using 10,000 simulations
of samples of varying length. All horizons k are in quarters.
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Stock Return Predictability
5.2 Size
Table 10 reports empirical sizes for tests of a 5% nominal (asymptotic)
size. In the shortest sample for the one-quarter horizon, the univariate
dividend yield regression displays negligible size distortions, but for the
bivariate regressions, all tests slightly over-reject at asymptotic critical
values. For longer horizons, the performance of the Newey–West and
robust Hansen–Hodrick estimators deteriorates, with the empirical size
exceeding 33% for a 5% test in the univariate dividend regression.10 For
our longer samples, these distortions become smaller but do not disap-
pear. For example, at the five-year horizon, the empirical size of the
dividend yield regression still exceeds 18.5% for both Newey–West and
robust Hansen–Hodrick estimators in the 267 quarter sample.
The Newey–West and robust Hansen–Hodrick standard errors are too
small because they underestimate the serial correlation in the error terms
as the autocorrelation estimates are downwardly biased. The Newey–West
standard error also uses a Bartlett kernel of declining, tent-shaped weights.
Under the null, the kernel is rectangular, so the Newey–West standard
errors underweight the effect of autocorrelations at long lags unless a higher
10
Hodrick standard errors also have relatively few size distortions, especially compared to Newey-West
standard errors, for standard linear VARs, like the Stambaugh (1999) system. Hodrick (1992) also
demonstrates that Hodrick standard errors are correctly sized for multivariate VARs.
683
684
2 tests
dy4 r dy4 joint across horizon
The table lists empirical size properties corresponding to a nominal size of 5% of Newey–West (1987) (N–W) with k þ 1 lags, Robust Hansen–Hodrick (1980) (Robust H–H) and
Hodrick (1992) t-statistics. We examine a univariate regression of excess returns on dy4 and a bivariate regression of excess returns on r and dy4 . We simulate 10,000 samples of
various lengths from the Null 2 Model (constant expected excess returns) and record the percentage of observations greater than the nominal critical values under the null
hypothesis of no predictability. The 2 tests report the proportion of rejections (using a 5% nominal size) for testing predictability jointly across horizons using Hodrick
standard errors. In the case of the bivariate regression, joint predictability of both short rates and log dividend yields is considered across horizons. All horizons k are in
quarters.
Stock Return Predictability
5.3 Power
5.3.1 Power in one country. Table 11 summarizes the size-adjusted
power for the Hodrick standard errors under Alternatives 1–3. Alterna-
tive 1 generates about the same predictive coefficient on the dividend yield
as observed in the data but the predictive power of the short rate is
unrealistically weak. Panel A shows that the power of the univariate
dividend yield regression is very small for the shortest sample, only
25.5% (12.1%) at the one-quarter (20-quarter) horizon. For the longer
samples, power rises to around 60% (40%) at the one-quarter (20-quarter)
horizon. The results for the bivariate regressions are quite similar, with
the power for the short rate coefficient slightly weaker than for the
dividend yield. Hence, power is only satisfactory for the long samples,
and even here, we might fail to reject the null of no predictability even
though predictability is truly present.
Alternative 2, reported in Panel B, generates as much short rate pre-
dictability as in the data but slightly overpredicts the univariate predictive
power of the dividend yield. For the 104-quarter length sample at short
horizons, the power of the univariate dividend yield regression is satisfac-
tory (55.2%). The power deteriorates with the horizon reaching 12.6% at
five years. Power increases substantially with the sample size; for our
longest sample, the Hodrick test has a power of over 97% at the one-
quarter horizon. If predictability in the data is as strong as under Alter-
native 2, it is unlikely that we failed to detect univariate predictability.
The power to detect the predictive ability of the short rate in the bivariate
regression is very high for all samples and at all horizons. In the bivariate
regression, there is little power to detect the true relation of future excess
returns with the dividend yield, because the dividend yield coefficient is
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Table 11
Size-adjusted power for Hodrick standard errors for one country
Sample Horizon
length (Qtrs) k-qtrs, dy4 r dy4 Univariate Bivariate
The table lists empirical power properties corresponding to a size-adjusted level of 5% of Hodrick (1992)
t-statistics. We examine a univariate regression of excess returns on dy4 and a bivariate regression of
excess returns on r and dy4 . We simulate 10,000 samples of various lengths from Alternatives 1–3 (Panels
A–C) and record the percentage of observations greater than the 5% critical values recorded under the
Null 2 Model (constant expected excess returns) using the simulations in Table 10. The 2 tests report the
proportion of rejections (using a 5% nominal size) for testing predictability jointly across horizons of
both short rates and log dividend yields. All horizons k are quarterly.
very small in the presence of the short rate as a predictor. Consistent with
this, the univariate joint 2 tests across horizons is very powerful, but the
power of the test in the bivariate regression is minimal.
Panel C reports the power under Alternative 3, which fits the data the
best. The power of the univariate tests is slightly better than the power
under Alternative 2. For the bivariate regression, the predictive coeffi-
cient of the short rate (dividend yield) is underestimated (overestimated)
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Table 12
Power properties for pooling cross-country data
Univariate Univariate
regression Bivariate regression regression Bivariate regression
4 4 2 4
k-qtrs dy r dy test dy r dy4 2 test
The table lists empirical power properties of Hodrick (1992) t-statistics, comparing a sample of one country of
increasing length versus a cross-sectional panel of countries, each of length 104 quarters. (The number of
observations 104 quarters corresponds to the sample period 1975–2001.) Power is taken corresponding to a
nominal (asymptotic) size of 5% using Alternative 3. We examine a univariate regression of excess returns on
log dividend yields and a bivariate regression of excess returns on short rates and log dividend yields. The 2
test reports a test for the joint predictability of the short rate and log dividend yield for a given horizon. The
population correlation coefficient between the excess returns of any two countries is 0.535.
688
Stock Return Predictability
Table 13
Predictability of excess returns by earnings yields
We estimate regressions of the form ~ytþk ¼ þ zt þ tþk,k , where ~ytþk is the cumulated and annualized k-period ahead return, with the instruments zt being log earnings yields
(univariate regression), or log dividend yields and log earnings yields (Lamont bivariate regression), or risk-free rates, log dividend yields, and log earnings yields (trivariate
regression). T-statistics in parentheses are computed using Hodrick (1992) standard errors. For Panel A (B), horizons k are quarterly (monthly). Panel B pools coefficients
jointly across the United States, United Kingdom, France, and Germany, constraining the coefficients to be the same across countries. The 2 test columns report a p-value for
a test that all the coefficients in each regression are jointly equal to zero.
*p<0.05.
*p<0.01.
Stock Return Predictability
691
692
Univariate
regression Lamont regression Trivariate regression 2 tests
We estimate regressions of the form ~ytþk ¼ þ z¢t þ tþk,k , where y~tþk is the cumulated and annualized k-period dividend or earnings growth, with the instruments zt being log
earnings yields (univariate regression), or log dividend yields and log earnings yields (Lamont bivariate regression), or risk-free rates, log dividend yields, and log earnings yields
(trivariate regression). T-statistics in parentheses are computed using Hodrick (1992) standard errors. For the quarterly US S&P data, horizons k are quarterly, whereas for the
monthly MSCI data horizons k are monthly. The pooled-country panels pool coefficients jointly across the United States, United Kingdom, France, and Germany,
constraining the coefficients to be the same across countries. The 2 test columns report a p-value for a test that all the coefficients in each regression are jointly equal to zero.
*p<0.05.
**p<0.01.
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coefficients are different from zero at the 1% level and the joint test also
rejects at the 1% level. The coefficients become smaller, and the statistical
significance weakens, with longer horizons. We still find predictability at
the 5% level for the one-year horizon, but only the earnings yield is
significant (at the 5% level) for the five-year horizon. Adding the risk-
free rate in the trivariate regression does not change this picture very
much, but a high short rate is also a very strong signal of lower future
dividend growth at the one- and four-quarter horizons. One possible
interpretation is that since interest rates are high during recessions and
recessions are persistent (Ang and Bekaert, 2002), high interest rates
predict low future cash flows. The negative dividend yield coefficient
can arise from prices reflecting future positive cash-flow prospects.
We find that the negative dividend yield and positive earnings yield
coefficients for predicting dividend growth are very robust across differ-
ent subsamples, but we do not report these results to conserve space. In
particular, omitting the 1990s, the signs of the coefficients are the same,
but the t-statistics are even larger in magnitude than the those reported
for the full sample. The inverse Lamont pattern is also robust in the
subsamples beginning in 1952.
When we pool data across countries using MSCI data, the cross-
sectional variation in the coefficients makes the cash-flow Lamont pattern
weaker, but it remains significant at the 1% level at the one-month
horizon, in both the bivariate and trivariate regressions. At longer hor-
izons, earnings and dividend yields do not predict future cash flows.
Moreover, the pattern is also repeated in the coefficients for each indivi-
dual country. Internationally, the short rate is not a robust predictor of
future cash flows, perhaps because the cyclicality of interest rates is not
consistent across countries.
In Panel B of Table 14, we repeat the same regressions for earnings
growth. The univariate regression with the earnings yield delivers a nega-
tive coefficient. The sign of this point estimate could be potentially con-
sistent with a standard price effect. However, it is statistically insignificant.
Interestingly, the sign of the dividend and earnings yield coefficients are
reversed for earnings growth, compared to dividend growth: for earnings
growth, we see a positive (negative) coefficient on the dividend (earnings)
yield. The effect is strongest for the earnings yield, which is significant at
the 5% level for the one- and five-year horizons, although borderline in the
latter case. Looking at the joint 2 tests, we conclude that there is some
evidence of cash-flow growth predictability at longer horizons (the p-value
is at most 0.057), primarily driven by the earnings yield. The 1952–2001
sample also preserves these coefficient patterns.
When we pool data across countries, the coefficients increase in mag-
nitude and the statistical significance increases considerably. All the joint
tests now reject at the 1% level, and even the short rate predicts cash-flow
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Stock Return Predictability
We can derive the results in the last column because the change in the
payout ratio equals (logarithmic) dividend growth minus earnings
growth. Hence, our results imply that higher dividend yields (higher
earnings yields) strongly predict lower (higher) payout ratios tomorrow.
Can we explain the reverse patterns for the two cash-flow measures for
dividend and earnings yields used jointly in predictive regressions? We
can rule out a Lamont (1998) story translated to cash flows. According to
Lamont, dividend yields capture price effects, whereas earnings yields
capture the cyclical component in earnings and hence potentially also
risk aversion. Under this scenario, we would expect the dividend yield to
be negatively related to earnings growth (the usual positive cash flow
prospects), but we find a positive effect.
When dividend yields are high today, we predict low dividend growth in
the future because payout ratios strongly decrease. This may be the result of
dividend smoothing, or it may reflect prices anticipating higher growth
opportunities that decrease the payout ratio. The positive relation between
current high dividend yields and future earnings growth implies that these
growth opportunities do not rapidly translate into higher future earnings.
The negative relation between the current earnings yield and future earnings
may be consistent with either a price effect or mean reversion in earnings.
The payout ratio reacts positively to an increase in the earnings yield. In the
mean reversion story, this could be an artifact of dividend smoothing. In the
price story, lower prices today may reflect poor future earnings and poor
future growth opportunities. The poor growth opportunities may increase
the payout ratio, particularly if dividends are sticky.
All in all, we find very strong evidence of dividend growth predictabil-
ity, both in US and international data, by using the dividend and earnings
yield jointly as predictors. We find weaker evidence in US data, but very
strong international evidence, of earnings growth predictability by
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The Review of Financial Studies / v 20 n 3 2007
7. Conclusion
The predictable components in equity returns uncovered in empirical
work over the last 30 years have had a dramatic effect on finance
research. Theoretical equilibrium models try to match the predictability
evidence as a stylized fact. The partial equilibrium dynamic asset alloca-
tion literature investigates the impact of the predictability on hedging
demands. Much of the focus has been on the predictive prowess of the
dividend yield, especially at long horizons. In this article, we pose the
question whether this predictability exists. After carefully accounting for
small sample properties of standard tests, our answer is surprising but
important. At long horizons, excess return predictability by the dividend
yield is not statistically significant, not robust across countries, and not
robust across different sample periods. In this sense, the predictability
that has been the focus of most recent finance research is simply not there.
Nevertheless, we do find that stock returns are predictable, calling for a
refocus of the predictability debate in four directions. First, our results
suggest that predictability is mainly a short-horizon, not a long-horizon,
phenomenon. The predictive ability of the dividend yield is best seen in a
bivariate regression with short rates only at short horizons. Second, the
strongest predictability comes from the short rate rather than from the
dividend yield. The result that the short rate predicts equity returns goes
back to at least Fama and Schwert (1977), but somehow recent research
has failed to address what might account for this predictability and has
mostly focused on the dividend yield as an instrument. Third, high
dividend yields predict high future interest rates. Finally, dividend and
earnings yields have good predictive power for future cash-flow growth
rates but not future excess returns. Hence, a potentially important source
of variation in price-earnings and price-dividend ratios is the predictable
component in cash flows. Our results generally imply that univariate
linear models of expected returns are unlikely to satisfactorily capture
all the predictable components in returns.
After our results were first distributed in a working paper article (Ang
and Bekaert, 2001), a number of articles have been written that confirm
them. Campbell and Yogo (2006) develop a new inference methodology
within the linear regression framework of Stambaugh (1999) and find that
the predictive power of the dividend yield is considerably weakened but
that the predictive power of the short rate is robust. Lettau and Ludvigson
(2005) also find that the price-dividend ratio weakly forecasts excess returns
but confirm that future dividend growth, long ignored by the literature, is
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Stock Return Predictability
X
k1
S^0 ¼ Cð0Þ þ ½CðjÞ þ CðjÞ , ðA1Þ
j¼1
where
1 X T
CðjÞ ¼ ðwtþk wtþkj Þ
T t¼jþ1
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0 1 0 1
htþk1 utþk1 xt
B .. C ¼ EB .. C
EðhtþkÞ E@ . A @ . A ¼ Eðutþk xt Þ ¼ 0, ðB2Þ
htþkn utþkn xt
S0 ¼ EðhtþkhtþkÞ ¼ E ðutþkutþkÞ ðxt x t Þ : ðB3Þ
^ b of S0 is given by
The Hodrick (1992) estimate S T
1
S^Tb ¼ W W , ðB4Þ
T
!
X
k1
wtþk ¼ etþ1 xti , ðB5Þ
i¼0
since under the null of no predictability the one-step ahead errors etþi ¼ utþ1 are uncorre-
lated and utþk ¼ etþ1 þ … þ etþk . Denoting X ¼ ðx 1 ,…x T Þ, T K, an estimate of Z01 is
given by
1
Z^T1 ¼ ½In ðXXÞ1 : ðB6Þ
T
ðC Þ½C ^ 1 C ^ 2
^ C ðB7Þ
rankðCÞ ,
^ ¼Z
with ^b Z
^ 1 S ^ 1
T T T .
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Stock Return Predictability
for i ¼ 1…N countries, subject to the restriction i ¼ 8i, but impose no restrictions on i
across countries. We take i ¼ United States, United Kingdom, France, and Germany.
Let the dimension of zt be ðK 1Þ so that there will be a total of K regressors, including
the constant terms i for each of N countries. In Equation (C1), we denote the free
parameters ¼ ð1 …N Þ and the unrestricted parameters stacked by each equation
¼ ð1 1 …N N Þ. We can estimate the system in Equation (C1) subject to the restriction
that C ¼ 0, where C is a NK ðN 1ÞðK 1Þ matrix of the form:
0 1
~0 I ~0 I ~0 : : :
B ~0 O ~0 I ~0 I ::: C
B C
C¼B .. C, ðC2Þ
@ . A
~0 O ~0 ~0 I
where ~
0 is a ðK 1Þ 1 vector of zeros, O is a ðK 1Þ ðK 1Þ matrix of zeros, and I is a
ðK 1Þ rank identity matrix.
Denote
y1tþk …~
y~tþk ¼ð~ yN
tþk Þ ðN 1Þ
xit ¼ð1zit Þ ðK 1Þ
utþk ¼ðu1tþk …uN tþk Þ ðN 1Þ
0 1 1 ðC3Þ
xt 0
B .. C
Xt ¼B@ .
C
A ðNK NÞ:
0 xN
t
Y ¼ X þ U, subject to C ¼ 0: ðC5Þ
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The Review of Financial Studies / v 20 n 3 2007
pffiffiffiffi a
T ð^ Þ Nð0,ðD 0 S01 D0 Þ1 Þ, ðC7Þ
with
@htþk
D 0 ¼ E
@
and
S0 ¼ Eðhtþk h tþk Þ:
^ b of S0 is given by
The Hodrick (1992) estimate S T
1X T
S^Tb ¼ wkt wkt , ðC8Þ
T t¼k
Under the null hypothesis of no predictability, utþk ¼ etþ1 þ …etþk , where etþ1 are the one-
step ahead serially uncorrelated errors. This is the SUR equivalent of the Hodrick (1992)
estimate for univariate OLS regressions.
An estimate D^ T of D0 is given by
XT
^ T ¼ 1
D
@htþk
,
T t¼0 @
and
where ¼ ð1 …N Þ
2 3
1 z1t 0
6 1 z2t 7
@htþk 6
6 ..
7
7
¼6 . 7:
@ 6 7
4 0 1 zN 5
t
z1t z1t z1t z2t z2t z2t ::: zN
t zN
t zt
N
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Stock Return Predictability
with
1X T
h ¼ htþk :
T t¼0
where "t are IID with Eð"t "t Þ ¼ . The unconditional covariance matrix of ut is given by:
y~tþ1 ~
ytþ1 ¼ ðXt Xt1 Þ þ "tþ1 ,
or as
where y*tþ1 ¼ ~
ytþ1 ~yt and Xt* ¼ Xt Xt1 . To construct y*tþ1 and Xt* , we use a con-
sistent estimate, ^ of . Using the estimate ^ of in Equation (C6), we set
,
P
^ ¼ 1=T vt v t1 , where vt are the residuals vt ¼ ~ytþ1 X t ^ that are standardized to
have unit variance.
To compute Cochrane-Orcutt standard errors for ¼ ð1 : : : N Þ in the pooled system
(C11) with matrix-autocorrelated residuals, we use GMM. The set of NK 1 moment
conditions implied by the regression (C13) are
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The Review of Financial Studies / v 20 n 3 2007
^ T of S0 ¼ Eðhtþ1 htþ1 Þ to be
We set the estimate S
1X T
S^T ¼ ^
½X * ðy* Xt* Þ:
T t¼1 t tþ1
Pt X 1
¼ Mtþi ,
Dt i¼1
where
" !#
X
i1 X
i
Mtþi ¼ Et exp tþj þ gdtþj : ðD1Þ
j¼0 j¼1
We show that
" !#
X
i X
iþ1
Mtþiþ1 ¼ Et exp tþj þ gdtþj
j¼0 j¼1
2
1
þ ðe2 þ bi þ ci ÞXt þ ðe2 þ bi þ ci Þðe2 þ bi þ ci Þ :
2
702
Stock Return Predictability
where aiþ1 , biþ1 , and ciþ1 take the form in Equation (10). The sum of exponential affine
functions of the price-dividend ratio means that this model falls under the class of affine
equity pricing models developed by Ang and Liu (2001), Bekaert and Grenadier (2002), and
Bakshi and Chen (2005).
Dt þ Dt1 þ Dt2 þ Dt3
gd,4
t ¼ log
Dt1 þ Dt2 þ Dt3 þ Dt4
d d d d d d
!
1 þ egt2 þ eðgt2 þgt1 Þ þ eðgt2 þgt1 þgt Þ
¼ gdt3 þ log :
d d d d d
1 þ egt3 þ eðgt3 þgt2 Þ þ eðgt3 þgt2 þgt1 Þ
d
ðE1Þ
Equation (E1) shows that the relation between quarterly growth rates and growth rates at a
quarterly frequency using dividends summed up over the past year is highly nonlinear. In
particular, the summing of dividends over the past four quarters induces serial correlation up
to three lags, even when gtd is serially uncorrelated.
To estimate the VAR on Xt , we impose a restricted companion form where 12 ¼ 0, so
there is no Granger-causality from dividend growth to interest rates. This assumption is
motivated by an analysis of an unconstrained VAR on ðrt gtd,4 Þ, where we fail to reject the
null that gtd,4 fails to Granger-cause interest rates. Hence, we first estimate an AR(1) on
quarterly short rates and then holding the parameters for rt fixed, we estimate the remaining
parameters in
, , and by using first and second moments of gtd,4 , in addition to the
moments Eðrt gtd,4 Þ, Eðgt4
d,4 d,4
gt Þ, and Eðrt4 gtd,4 Þ. Hence, the system is exactly identified. The
cross-moment lag length is set at four because the first three lags are affected by the
autocorrelation induced by the nonlinear filter for annual dividend growth in Equation
(E1). We compute the Newey–West (1987) weighting matrix with four lags using the data, so
we do not need to iterate on the weighting matrix.
In the second stage, we hold the parameters of the VAR fixed at their estimates in Panel
A. The parameters , , , and
2 are estimated by matching 12 moment conditions: the
first and second moments of excess returns ~yt and dividend yields D4t =Pt in the data, with
d,4
rt1 and gt1 as instruments. Hence, we use the moments
E½qt zt1 ¼ 0,
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The Review of Financial Studies / v 20 n 3 2007
The relation between the closed-form quarterly dividend yields dyt (Proposition 4.1) and
the dividend yields in the data dy4t (which use dividends summed over the last 4 quarters) is
complex:
where the capital gain over n periods Pt =Ptn can be evaluated using:
!
Pt Pt =Dt X
n1
¼ exp gdti :
Ptn Ptn =Dtn i¼0
The predictability regressions use excess log returns y~tþ1 ¼ logðYtþ1 Þ rt , where
Yt ¼ logððPtþ1 þ Dtþ1 Þ=Pt Þ. Since we model t ¼ logðEt ðPtþ1 þ Dtþ1 Þ=Pt ÞÞ, the expected
log excess return Et ðlogðYtþ1 Þ rt Þ 6¼ ðlog Et ðYtþ1 Þ rt Þ is not closed form in our model
but is a function of time t state variables because of the Markov structure of the model. The
two quantities Et ðlogðYtþ1 Þ rt Þ and ðlog Et ðYtþ1 Þ rt Þ are not equal because of the pre-
sence of state-dependent heteroskedasticity, which induces (time-varying) Jensen’s inequal-
ity terms. To compute the conditional expected value of k-period excess returns, we project
excess returns onto a fourth-order polynomial in ðXt , t Þ, and the fitted value is the model-
implied conditional expected excess return.
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